FASB Simplification and Codification Project
Principles-Based Approach to Standard Setting
From FASB newsletter The FASB Report, November 27, 2002
By Linda A. MacDonald, Project Manager
Recently, many have expressed concerns about the quality and transparency of financial reporting in the United States. In response, the FASB has issued for public comment a proposal for a principles-based approach to U.S. standard setting and plans to hold a public roundtable meeting with respondents to the proposal on December 16. In addition, the Sarbanes-Oxley Act of 2002 requires the Securities and Exchange Commission (SEC) to conduct a study on the adoption of a similar approach and to submit the results of that study to Congress by July 2003.
The idea of a principles-based approach to U.S. standard setting is not new. The Board’s conceptual framework contains the body of principles that underlies U.S. accounting and reporting. The Board has used the conceptual framework in developing the principles in accounting standards for more than 20 years. However, many assert that the standards have become increasingly detailed and rules-based (with “bright-lines” and “on-off” switches that focus on the form rather than the substance of transactions), complex, and difficult and costly to apply. Many also assert that the standards allow financial and accounting engineering to structure transactions “around” the rules, referring to situations such as those in which complex structures or a series of transactions are created to achieve desired accounting results; for example, to remove assets from the balance sheet while retaining the overall economics of the assets or to recharacterize assets.
Under a principles-based approach, the principles in accounting standards would continue to be developed from the conceptual framework, but would apply more broadly than under existing standards, thereby providing few exceptions to the principles. In addition, the FASB and other standard-setting bodies would provide less interpretive and implementation guidance for applying the standards. Because exceptions and interpretive and implementation guidance are largely demand-driven, a principles-based approach would require changes in the processes and behaviors not just of the FASB and other standard-setting bodies, but of all participants in the U.S. financial accounting and reporting process-including preparers, auditors, the SEC and users of financial information. Significant changes are discussed below.
Few, if Any, Exceptions
Exceptions in accounting standards create situations in which the principles in the standards do not apply. Under a principles-based approach, it might not be possible to eliminate all exceptions. However, the Board believes that an objective of that approach should be to eliminate exceptions that are intended to achieve desired accounting results (for example, to limit volatility of reported earnings), which may obscure the underlying economics of the related transactions and events. To achieve that objective, the Board would need to resist pressures to provide exceptions in accounting standards. In turn, others (preparers and users of financial information) would need to accept the consequences of applying accounting standards with fewer exceptions to the principles, including increased volatility in reported earnings.
Implementation of Principles-Based Standards
In addition to the FASB, other standard-setting bodies, including the FASB Emerging Issues Task Force (EITF) and the AICPA Accounting Standards Executive Committee (AcSEC), provide interpretive and implementation guidance for applying accounting standards. A principles-based approach would not eliminate the need for interpretive and implementation guidance. However, the Board believes that an objective of that approach should be to provide interpretive and implementation guidance that focuses only on significant matters addressed in the standards, thereby increasing the need to apply professional judgment in the situations not addressed. In commenting on the proposal, Robert H. Herz, FASB Chairman, explained, “To me, it’s a matter of where you start, where you stop and what’s your home base. Under a principles-based approach, one starts with laying out the key objectives of good reporting in the subject area and then provides guidance explaining the objective and relating it to some common examples. While rules are sometimes unavoidable and the guidance should be sufficient to enable proper implementation of the principles, the intent is not to try to provide specific guidance or rules for every possible situation. Rather, if in doubt, the reader is directed back to the principles.” He added that a principles-based approach, while desirable, would require participants to exercise good professional judgment and “resist the urge to seek specific answers and rulings on every implementation issue.”
To achieve an objective of providing interpretive and implementation guidance that focuses only on significant matters addressed in the standards, the Board and other standard-setting bodies would need to resist pressures to provide interpretive and implementation guidance addressing all possible applications of the standards. In that regard, the Board would need to establish guidelines sufficient to identify situations in which interpretive and implementation guidance in accounting standards is appropriate. To ensure that those (or similar) guidelines are applied consistently after the standards are issued and to improve consistency in establishment of standards, the FASB is taking the lead in realigning the structure of U.S. standard setting. Among other things, the FASB is implementing changes to the roles and processes of the EITF whereby the FASB will have more direct involvement with the agenda, deliberations and conclusions of the EITF. Also, in collaboration with the AICPA, the FASB has proposed that AcSEC cease issuing Statements of Position that create new U.S. GAAP. While the AICPA would continue to issue industry accounting and auditing guides by way of implementation guidance, the FASB would take on the responsibility for the standard-setting role filled currently by AcSEC.
In any event, preparers and auditors would need to apply professional judgment in more situations. In turn, the SEC and users of financial information would need to accept the consequences of applying professional judgment in more situations, including some divergence in practice.
The Board believes that an approach focusing more clearly on the principles in accounting standards is necessary to improve the quality and transparency of U.S. financial accounting and reporting. Also, a principles-based approach is similar to the approach used by the International Accounting Standards Board (IASB) in developing International Financial Reporting Standards (IFRS). Thus, adopting such an approach could facilitate convergence as the FASB works with the IASB and other national standard setters in developing common high-quality accounting standards. The Board believes that if all participants in the U.S. financial accounting and reporting process are willing to make the changes required under a principles-based approach, the benefits of adopting that approach would outweigh its costs.